Hedge Fund Pain Sends Stocks on Wild Ride

The sharp market declines on Wednesday that were exacerbated by rumors of poor performance at a leading hedge fund may only be the tip of the iceberg, as heavily leveraged funds are forced to liquidate more assets.

The Dow Jones Industrial Average plunged 733 points Wednesday as reports circulated that a key fund run by Citadel Investments, a large, Chicago-based hedge fund, was down more than 30%. Citadel acted quickly to dispel the rumors, but acknowledged that challenging market conditions last month had led to the worst performance in its history.

Wednesday's decline was the latest in a series of enormous dips and peaks in the market, as it has swung wildly on uncertainty about underlying fundamentals. But deleveraging, short squeezes and automated trades have also come to play a huge role in exacerbating gains and losses. Hedge funds that use borrowed money to amplify their bets and byzantine derivative investments to offset losses are contributing mightily to the off-the-charts volatility.

"Hedge funds are the most active part of the market, they do the most transactions," says K. Daniel Libby, senior portfolio manager of the Select Access hedge funds for Sands Brothers Asset Management. "Furthermore, as a backdrop, there's less trading going on generally in a lot of sectors of the market, and people everywhere are holding greater amounts of cash. Therefore, the impact hedge fund managers are having is even more pronounced in a market such as this for those hedge funds who are executing transactions."

All told, the Dow has varied 3,250 points so far this month, from a height of 11,022.06 on Oct. 1 to a low of 7,773.71 on Oct. 10. Components like General Electric (GE), Coca-Cola (KO) and Boeing (BA) traded under 52-week lows on Thursday.